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Measuring by GDP Shares, There Is No Shortfall

Don, I was referring to shares of GDP. In the case of consumption, the savings rate was almost zero in the years from 2004 to 2007. (There are some issues with the data related to the statistical discrepancy. We find evidence that capital gains income was erroneously counted as ordinary income, leading to an overstatement of the savings rate during these years). It had been over 5.0 percent for in 2009 and 2010, although it slipped down to 3.8 percent in the most recent quarter. The gap between a saving rate of 5.0 percent and a saving rate of zero corresponds to $500 billion in lower annual demand.

I did refer to gross non-residential investment. It is more common to use gross rather than net figures both because gross is what determines demand and net is not very well measured. I should have also specified investment in equipment and software. There was huge overbuilding in most categories of non-residential construction in the pre-recession period as there was a bubble in non-residential construction that followed on the heels of the bubble in residential real estate. This measure on investment stood at 7.5 percent of GDP in the most recent quarter. It averaged 7.9 percent of GDP in 2007. The gap corresponds to a shortfall in demand of roughly $60 billion a year.

If we want to take a net measure, net investment in equipment and software was 1.5 percent of GDP in 2007. It was 0.5 percent in 2010, the last period for which we have data. This would imply a gap of 1.0 percentage point of GDP, or roughly $150 billion a year. However, given the growth in gross investment in the last four quarters, it is likely that close to half of this gap would be eliminated by the third quarter, leaving a gap in net investment in equipment and software of around 0.5 percent of GDP, roughly the same as the gap in gross investment.

In short, I don’t see that we have any real shortfall of investment to explain. If anything, given the unusually low rates of capacity utilization, investment in equipment in software is surprisingly high. The downturn is caused by the lack of consumption demand associated with the loss of $8 trillion of housing wealth and the loss of construction demand (both residential and non-residential), which is attributable to the overbuilding of the bubble years.

Also from This Issue

Tim Congdon argues that John Maynard Keynes’ latter-day followers have badly misinterpreted the theorist they profess to follow. Led by Paul Krugman, Keynesians have claimed that a near-zero Federal Funds rate is indicative of a liquidity trap. This diagnosis has several problems. First, it is not what Keynes meant by the term; second, even a rate of zero percent does not exhaust monetary policy; and third, a genuine Keynesian liquidity trap has not happened and cannot plausibly happen, in part but not solely because Keynes assumed constant prices throughout the economy, a condition that is unlikely in the face of a rising money supply. Congdon commends to readers Milton Friedman’s monetary prescription: a gradually and predictably rising supply of money, not the wild swings we have seen in recent years.

Dean Baker argues that Keynesians have not given up on monetary policy. Although the federal funds rate can’t go negative, the Federal Reserve can still set a higher inflation target, a solution both he and Paul Krugman endorse. Alongside monetary policy, Baker recommends fiscal policy: The recent economic stimulus legislation worked as intended, he argues, although the recession was more severe than the administration anticipated, and thus the stimulus proved to be too small. Policymakers have a duty to try to return the country to full employment, as the unemployed, who are suffering the most in the current crisis, are not to blame for their troubles.

Don Boudreaux agrees with Congdon that a monetarist policy approach would be preferable, but he draws our attention to a third relevant consideration: regime uncertainty, as described by the economist Robert Higgs. When businesses are uncertain about the major economic decisions of governments and central banks, they will defer new investments and retain cash rather than hiring new workers. Neither monetarism nor Keynesianism does anything to address the problem, which Keynes himself conceded was real.

Robert Hetzel reiterates that a zero lower bound for interest rates is a different phenomenon from a liquidity trap. The latter is an “irrelevant academic construct” as long as the central bank can create new money. Still, we learn little from this distinction unless we can determine the nature of the initial shock that caused pessimism among market participants; different types of shocks, monetary and real, call for different remedies. Central banks rarely use the analytical tools that would be necessary for them to evaluate their own roles in economically rigorous ways; instead, they tend to blame difficult times on the private sector, while taking credit for good ones.

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